The Case for a Market in Debt Goverance

Scholars have long lamented that the growth of modern finance has given way to a decline in debt governance. According to current theory, the expansive use of derivatives that enable lenders to trade away the default risk of their loans has made these lenders uninterested, even reckless, when it comes to exercising creditor discipline. In contrast to current theory, this Article argues that such derivatives can prove a positive and powerful influence in debt governance. Theory has overlooked those who sell credit protection to lenders and assume default risk on the borrower. These protection sellers are left holding the economic risk of a loan without any legal control rights to safeguard their exposure. This Article demonstrates that the interests of lenders and protection sellers are not necessarily adversarial, as theory conventionally assumes. Rather, each side has considerable incentive to cooperate as a way to reduce its own costs of participating in the debt market and to preserve reputational capital. Recognizing this potential for cooperation, this Article proposes a market for creditor control as a cure to the crisis in debt governance. Such a market would allow lenders and protection sellers to trade control rights in debt to ensure that they are held by those with real economic skin in the game. This market aims to offer a fix to an otherwise difficult and costly problem: the misalignment seen in modern markets between those who bear the economic risk in debt and those best able to control it

The Specter of Sisyphus: Re-Making International Financial Regulation After the Global Financial Crisis

The global financial crisis is forcing a thorough re-evaluation of the international regulatory architecture. The crisis has shown not only the cracks in regulatory oversight, but also a market operation that had long outgrown and outwitted its overseers. This Article has argued that the international financial market may be seen as having its own distinct personality, the recent expansion bringing with it a unique set of regulatory risks. Accordingly, just as with domestic regulatory systems, the regulation of the international financial marketplace ought to be rooted in the legal and economic rationales that have been advanced in support of financial markets regulation generally, in order that reform proceed thoughtfully, rather than on an ad hoc and knee-jerk basis. This Article contemplates a re-organization of the current plethora of standard-setting and oversight bodies that have provided little substantial protection in the face of the crisis. In sum, it puts forward a case for a more consolidated framework for standard setting and supervision that better matches the shape that the market has assumed, and that further works to ensure a greater focus on catching and managing the dangers of cross-border systemic risk

Oversight Failure in Securities Markets

According to statute, securities exchanges play an essential role in ensuring compliance with applicable laws and industry standards. Long imagined as unique in their institutional capacity to bring traders together, collect information and exclude problem participants from the marketplace, exchanges have offered an efficient source of private discipline for public regulators. The classic conception of the exchange, however, no longer holds true in today’s markets. Rather than concentrate activity within a handful of exchanges, equity markets are fragmented across a network of 14 exchanges and around 40 lightly regulated, off-exchange alternative venues (colloquially, “dark pools”). This Article shows that the goal of exchange oversight is rendered unachievable in fragmented markets. First, exchanges no longer constitute the central forums for convening traders, who now enjoy enormous choice regarding where and how to trade. Fragmentation also increases the costs of performing oversight and reduces its effectiveness. Exchanges must work harder to collect information across multiple exchanges and dark pools. Tough enforcement can result in lost business. And the power to exclude traders from the exchange is weak where traders can move fluidly to other venues. Secondly, exchanges have incentives to under-invest in oversight. They reap private gains by winning business, but share the risks of losses with competitor exchanges and dark pools. This Article proposes a structural solution to motivate stronger surveillance, outlining a new liability regime for exchanges and dark pools. Liability aligns the incentives of trading venues towards delivering oversight. In so doing, it helps recapture the benefits of consolidation, while maintaining competition in market structure

The Case for a Market in Debt Governance

Scholars have long lamented that the growth of modern finance has given way to a decline in debt governance. According to current theory, the expansive use of derivatives that enable lenders to trade away the default risk of their loans has made these lenders uninterested, even reckless, when it comes to exercising creditor discipline. In contrast to current theory, this Article argues that such derivatives can prove a positive and powerful influence in debt governance. Theory has overlooked those who sell credit protection to lenders and assume default risk on the borrower. These protection sellers are left holding the economic risk of a loan without any legal control rights to safeguard their exposure. This Article demonstrates that the interests of lenders and protection sellers are not necessarily adversarial, as theory conventionally assumes. Rather, each side has considerable incentive to cooperate as a way to reduce its own costs of participating in the debt market and to preserve reputational capital. Recognizing this potential for cooperation, this Article proposes a market for creditor control as a cure to the crisis in debt governance. Such a market would allow lenders and protection sellers to trade control rights in debt to ensure that they are held by those with real economic skin in the game. This market aims to offer a fix to an otherwise difficult and costly problem: the misalignment seen in modern markets between those who bear the economic risk in debt and those best able to control it

The Problematic Forgotten Buyback

Totaling in excess of $100 billion dollars in transactions annually, debt buybacks allow a company to repurchase bonds from investors, rewriting bargains and stripping away creditor control rights in the process. This Article shows that regulation systematically underprotects bondholders in the context of debt buybacks. It makes three points. First, bondholders confront information asymmetries that enable issuers to buy back creditor claims cheaply. Regulation imposes near negligible requirements on issuers to disclose information about the transaction. Lacking fiduciary protection, bondholder interests are vulnerable to being extinguished by issuers in the interests of promoting those of shareholders and managers. Second, buybacks diminish the power of creditor control rights. Alongside information asymmetries, bondholders confront coordination costs and tight deadlines within which to evaluate the terms of a buyback and changes to bondholder control rights. Owing to these costs, issuers can systematically underprice control rights. Bondholders will not act where the gains of agitation will be less than the cost of information gathering, coordination, and action. By strategically underpricing a buyback by an amount approximating these transaction costs, an issuer can pocket the difference between the price paid for the claim and that which should have been paid to bondholders for their bargain. Third, debt buybacks can allow one set of creditors-—notably, banks-—to extract value from bondholders. By pushing an issuer to buy back bond claims cheaply, banks-—usually with greater individual exposure through loans-—can increase their chances of being repaid. They can also acquire a more powerful voice in the issuer’s internal governance by muting that of bondholders. In highlighting regulation’s forgotten but problematic buyback, this Article offers two proposals to bolster bondholder protection, advocating for greater disclosure and contractual fixes to safeguard the value of claims. These proposals help to preserve the welfare of investors and protect their longer-term confidence in debt capital allocation

Insider Information and the Limits of Insider Trading

This article, by Professor Yesha Yadav of Vanderbilt Law School, examines modern information flows by which securities are bought and sold and argues that the instantaneous processing of market information by high-frequency trading institutionalizes a group of “structural insiders” who can take advantage of information earlier than those on the outside. Yadav analogizes the advantages enjoyed by these structural insiders to those found in the context of corporate insider trading and asks why each is subject to different treatment under the law

Insider Trading and Market Structure

This Article argues that the emergence of algorithmic trading raises a new challenge for the law and policy of insider trading. It shows that securities markets comprise a cohort of algorithmic “structural insiders” that – by virtue of speed and physical proximity to exchanges – systematically gain first access to information and play an outsize role in price formation. This Article makes three contributions. First, it introduces and develops the concept of structural insider trading. Securities markets increasingly rely on automated traders utilizing algorithms – or pre-programmed electronic instructions – for trading. Policy allows traders to enjoy important structural advantages: (i) to physically locate on or next to an exchange, shortening the time it takes for information to travel to and from the marketplace; and (ii) to receive feeds of richly detailed data directly to these co-located trading operations. With algorithms sophisticated enough to respond instantly and independently to new information, co-located automated traders can receive and trade on not-fully-public information ahead of other investors. Secondly, this Article shows that structural insider trading exhibits harms that are substantially similar to those regulated under conventional theories of corporate insider trading. Structural insiders place other investors at a persistent informational disadvantage. Through their first sight of market-moving data, structural insiders can capture the best trades and erode the profits of informed traders, reducing their incentives to participate in the marketplace. Despite the similarity in harms, however, this Article shows that doctrine does not apply to restrict structural insider trading. Rather, structural insiders thrive in full view and with regulatory permission. Thirdly, the Article explores the implications of structural insider trading for the theory and doctrine of insider trading. It shows them to be increasingly incoherent in their application. In protecting investors against one set of insiders but not another, law and policy appear under profound strain in the face of innovative markets

Oversight Failure in Securities Markets

According to statute, securities exchanges play an essential role in ensuring compliance with applicable laws and industry standards. Long imagined as unique in their institutional capacity to bring traders together, collect information and exclude problem participants from the marketplace, exchanges have offered an efficient source of private discipline for public regulators. The classic conception of the exchange, however, no longer holds true in today’s markets. Rather than concentrate activity within a handful of exchanges, equity markets are fragmented across a network of 14 exchanges and around 40 lightly regulated, off-exchange alternative venues (colloquially, “dark pools”). This Article shows that the goal of exchange oversight is rendered unachievable in fragmented markets. First, exchanges no longer constitute the central forums for convening traders, who now enjoy enormous choice regarding where and how to trade. Fragmentation also increases the costs of performing oversight and reduces its effectiveness. Exchanges must work harder to collect information across multiple exchanges and dark pools. Tough enforcement can result in lost business. And the power to exclude traders from the exchange is weak where traders can move fluidly to other venues. Secondly, exchanges have incentives to under-invest in oversight. They reap private gains by winning business, but share the risks of losses with competitor exchanges and dark pools. This Article proposes a structural solution to motivate stronger surveillance, outlining a new liability regime for exchanges and dark pools. Liability aligns the incentives of trading venues towards delivering oversight. In so doing, it helps recapture the benefits of consolidation, while maintaining competition in market structure

The Problematic Case of Clearinghouses in Complex Markets

This Article challenges the academic and policy consensus that clearinghouses adequately mitigate the risks of trading credit derivatives. The Article advances two arguments. First, scholars have devoted little attention to the risks posed by underlying assets (e.g. a mortgage loan) that the credit derivative references and the impact that these have on the clearinghouse. Credit derivatives enable the economic risk of debt to be separated from the legal rights attaching to that debt. This separation impacts the clearinghouse profoundly. As a contract party to each trade it processes, the clearinghouse can be saddled with economic risk of underlying debt without the legal rights necessary to mitigate its exposure. If a clearinghouse cannot manage its risks, the consequences are invariably systemic and enormously costly to the taxpayer. Second, the Article shows that clearinghouse members are subject to complex incentives that: (i) actually encourage risk-taking by subsidizing its cost; (ii) allow parties to shift the private costs of monitoring to the clearinghouse and themselves under-invest in due diligence; and (iii) create undue reliance on information that is impressed by the strategic motives of parties providing it. This Article, finally, proposes a new paradigm for the clearinghouse. This model seeks to repair the consequences of the separation between economic risks and legal rights enabled by the credit derivative – as well as control the perverse incentives affecting clearinghouse members. With the clearinghouse having better powers to police its exposures, the Article proposes that reform can make the clearinghouse a more robust institution and control lax underwriting standards more broadly

Insider Trading in Derivatives Markets

The prohibition against insider trading is becoming increasingly anachronistic in markets where derivatives like credit default swaps (CDS) operate. Lenders use these instruments to trade the credit risk of the loans they extend. By design, CDS appear to subvert insider trading laws, insofar as lenders rely on what looks like insider information to transfer or externalize the risk of a loan to another institution. At the same time, the harm caused by using insider information in CDS markets can depart radically from the harms envisioned under existing case law. In the traditional account of insider trading, shareholders systematically lose against informed insiders. However, with CDS trading, shareholders of the debtor company can emerge as winners where this company enjoys access to cheaper credit and lower funding costs. A thorough re-thinking of traditional theory is thus required, as well as a more robust, theoretical account of the efficiency and welfare implications of insider trading in a world animated by complex derivatives markets. This Article shows that trading on insider information in CDS can improve at least the informational, if not also the allocative efficiency of financial markets in ways traditional accounts have scarcely anticipated. However, in doing so, CDS markets reveal that this informational gain can render markets too efficient where they impound new information selectively and with such force that market stability itself can suffer. Collectively, these observations suggest a need to revisit the insider trading prohibition itself – and to explore whether consistency can (and should) be brought to supervisory approaches in U.S. equity and derivatives markets